Well-Oiled Machine

By

Erin E. Arvedlund

Updated Jan. 6, 2003 12:01 am ET / Original Sept. 15, 2019 5:38 am ET

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THE RECENT SURGE in oil prices has done precious little for the stocks of the world's oil giants. Although crude is up more than 25% since mid-November -- surpassing $30 a barrel amid the strikes in Venezuela and the showdown with Iraq -- big-oil shares have barely budged. Most are hovering at or below the midpoints of their 52-week ranges. But far from being a dry well, the sector could offer some real opportunity for investors.

Royal Dutch Petroleum,
the majority owner of the globe-girdling Royal Dutch/Shell Group, looks like an especially good value. It trades at a discount to industry leader
ExxonMobil,
boasts a strong balance sheet and pays a handsome dividend. And if oil prices decline, perhaps following a successful invasion of Iraq, Royal Dutch could suffer less than rivals; its earnings are considered somewhat less sensitive to price swings.

Royal Dutch, based in the Netherlands, makes nearly all its money from its 60% stake in the Royal Dutch/Shell Group, the third-largest oil and gas concern after ExxonMobil and
BP.
British-based Shell Transport & Trading holds the other 40%, in an unusual arrangement dating back to an alliance struck in 1907. Investors participate in Royal Dutch/Shell by buying the stock of either Royal Dutch or Shell. The former is by far the more liquid of the two and currently trades at a small discount to the latter.

The appeal of Royal Dutch's stock stems in part from an unusual pounding it took in 2002. The company, along with six other non-U.S. outfits, was booted from the Standard & Poor's 500 in July, because foreign companies supposedly caused tracking errors in the index. Managers of index funds immediately began dumping Royal Dutch; the shares dropped from 57 to the low 40s and never recovered. "A lot of people arbitrarily had to sell it," says value maven Seth Glickenhaus, founder of asset manager Glickenhaus & Co. "The stock lost its cachet, but it's still a great company. Eventually, that will be realized."

Indeed, he and others say the stock, recently trading at 44, could easily return to 50 in the coming months. Within a year or two, some investors believe it will be back in the high 50s.

Royal Dutch looks especially tempting compared with ExxonMobil, almost a must-own stock for many institutions. Royal Dutch trades at about 15 times estimated earnings for 2003, compared with 18 for ExxonMobil and for the broader stock market. And analysts expect both companies to post similar profit growth over the next five years -- about 8% a year.

Most important, Royal Dutch offers a dividend yield of 3.6%, compared with 2.6% for ExxonMobil. In fact, big oil as a group offers some of the highest dividends around, rivaling or surpassing the benchmark 10-year Treasury note's 4%.
ChevronTexaco
's yield is 4.1%; BP's, 3.9%.

The sector could be a prime beneficiary of the dividend-tax reform under discussion in Washington. If taxes are cut for corporations and investors, it's possible that high-yielding companies will gain more admirers. "If double-taxation relief comes into play, this is a great opportunity," says Bruce Lanni, an analyst at A.G. Edwards & Sons.

The oil patch, however, is never without bumps, and the past year was no exception. With world economies flagging, big oil saw earnings sag. ChevronTexaco, still struggling to integrate Texaco and saddled with a position in scandal-scarred
Dynegy,
posted a third-quarter loss of $904 million. Royal Dutch/Shell, though faring better than most rivals, still reported third-quarter earnings declined to $2.24 billion from $2.6 billion, on a "current cost of supplies" basis (comparable with earnings reports of U.S.-based companies). Revenue for the third quarter rose to $63.4 billion from $43.1 billion a year earlier.

Analysts expect Royal Dutch's earnings to climb 13% this year, to $2.98 a share, according to Thomson Financial's First Call. The company has been cutting costs and integrating recent acquisitions, including Enterprise Oil of the United Kingdom, which it bought for $6.2 billion in 2002. And any improvement in the economy will help by boosting demand for oil.

Meanwhile, the company is enjoying the benefits of a solid balance sheet. Debt stood at 22.7% of total capital at the end of the third quarter, and the company had $4.3 billion of cash on hand. Cash flow from operations was $5.6 billion for the quarter, up from $3.5 billion a year earlier.

The biggest challenge for Royal Dutch lately has been dwindling margins at its refineries, which buy crude from the company's production side and turn it into heating oil, gasoline and other products. Unless demand for those products is strong, rising crude costs cut into profits sharply -- and demand has clearly been weak.

However, refining margins may be bottoming. After declining sharply in November, the U.S. composite refining margin is now averaging $4.63 a barrel, compared with $3.70 a year ago, according to A.G. Edwards estimates.

And Wall Street expects crude, which last week hit a two-year high of $33 a barrel, to slide as low as $20 later this year if the Organization of Petroleum Exporting Countries manages to boost supply sufficiently and if an invasion of Iraq proves to be swift and decisive. Current prices appear to include a "war premium" of $5 to $6 barrel. Although prices could spike in the next month or two, the futures market is already reflecting much lower tabs by year end; oil to be delivered next December has recently been priced at $24.40 a barrel. "Based on our scenario of an economic recovery, combined with a fall in crude oil prices, we expect refining margins to turn upward in 2003," SG Securities wrote in a recent research report.

Falling oil prices, of course, would hurt exploration and production earnings. As with other oil giants, those are the big drivers at Royal Dutch, accounting for about 75% of total earnings. But while refining margins have been under unusual pressure lately, the production and refining businesses tend to balance each other out over time and hold down volatility for Royal Dutch. The result: A $1 rise or fall in the price of a barrel of oil generally lifts or cuts earnings by just 3.85%, compared with more than 4% for ExxonMobil and BP, and more than 6% for ChevronTexaco, according to A.G. Edwards & Sons.

And what does Royal Dutch say about its outlook? Both Royal Dutch and Shell declined to make executives available for interviews with Barron's, citing a quiet period ahead of an important February analyst meeting.

In fact, the company's communications with investors -- or lack thereof -- have been a sore point. Soon after Phil Watts became executive chairman in July 2001, he announced that the energy giant's target for increases in oil and gas output -- then 5% -- was being put under review. But he didn't announce the new target, 3%, for months. Then, when releasing third-quarter earnings in October, the company wouldn't say if 3% was still the target. Investors are hoping guidance will emerge next month.

Simply put, the company needs to build investor confidence, says Charles Ober, manager of the T. Rowe Price New Era fund. "They have to deliver above forecasts or have some exploration successes meaningful to the bottom line," he says.

Oil production at Royal Dutch totaled 810 million barrels in 2001, compared with 918 million for ExxonMobil and 714 million for ChevronTexaco. Proved reserves among the majors are ranked similarly: Royal Dutch's total 9.47 billion barrels, ExxonMobil's, 12.31 billion, and ChevronTexaco's, 8.52 billion.

Replacement of reserves is an ever-pressing issue for Royal Dutch and its rivals. The companies dug deeper into their wallets last year to find fossil fuels and have been turning to new geographic areas. "It's a mature industry -- this is the aging process of reserves," says Fadel Gheit, an analyst at Fahnestock & Co.

The bigger the company, the harder it is to replace existing reserves. And it's costing more to do so. The "replacement percentage" for the industry has risen from an average of 169% to 205% over the past three years -- meaning companies are finding a little more than two new barrels of oil for every one produced. But for biggies such as Royal Dutch and ExxonMobil, maintaining that percentage is becoming more difficult because they have so many barrels to replace each year. Royal Dutch's average annual replacement percentage has dropped from a 128% average over the past 10 years to 97% in the past three.

Industrywide, the cost of finding reserves rose by 60% last year, pushing up the total cost to the equivalent of $5.31 a barrel, according to the energy consulting firm John S. Herold.

Meanwhile, Royal Dutch continues to tend to its own house. In addition to integrating Enterprise Oil, which boosted its position in the North Sea, the company has been absorbing lubricant marketer Penzoil-Quaker State.

And together with Saudi Refining, the company last year bought Tuxedo's interests in two units that refine oil and run gas stations in the U.S. One, Motiva Enterprises, serves the East and South; the other, Equilon Enterprise, operates in the West. Texaco agreed to give up the operations to win antitrust approval of its merger with Chevron.

Although Watts has been on the job only a year and a half, he is, at 56, just four years short of mandatory retirement age. So succession looms as another issue.

Historically, the chairmanship has rotated among three groups: Royal Dutch Petroleum, Shell and the company's central exploration unit. But precedent was ignored last time around. Although it was the Dutch unit's turn to provide a leader, the board went with Watts, then the energy titan's head of exploration.

Right now, the betting favors Walter van de Vijver, who succeeded Watts in the exploration post. The president of Royal Dutch Petroleum, Jeroen van der Veer, is also seen as a candidate, one who would restore the tradition of rotation.

But petroleum prices and profitability are most important to Royal Dutch's prospects. And in 2003, those are likely to move in its favor, making it a well-oiled machine.

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